Bankruptcy, Counterparty Risk, and Contagion
AbstractThis paper provides a unifying framework for the modeling of various types of credit risks such as contagion effects. We argue that Markov chains can efficiently be used to tackle these problems. However, our approach is not limited to pricing problems with contagion. Other applications include the modeling of a more sophisticated default process of a firm. On the theoretical side, we derive pricing formulas for three building blocks that are generalizations of contingent claims studied in Lando (1998). These claims can be thought of as atoms forming the basis for all credit risky payments. Furthermore, we demonstrate that, in general, all contingent claims exposed to credit risk satisfy a system of partial differential equations. This is the key result to calculate prices of credit risky claims explicitly and efficiently.
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Bibliographic InfoPaper provided by University of Copenhagen. Department of Economics. Finance Research Unit in its series FRU Working Papers with number 2006/03.
Length: 36 pages
Date of creation: May 2006
Date of revision:
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default risk; financial distress; default correlation; contagion; Markov chains;
Find related papers by JEL classification:
- G13 - Financial Economics - - General Financial Markets - - - Contingent Pricing; Futures Pricing
This paper has been announced in the following NEP Reports:
- NEP-ALL-2006-06-10 (All new papers)
- NEP-CBA-2006-06-10 (Central Banking)
- NEP-CFN-2006-06-10 (Corporate Finance)
- NEP-FIN-2006-06-10 (Finance)
- NEP-FMK-2006-06-10 (Financial Markets)
- NEP-RMG-2006-06-10 (Risk Management)
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